Will anyone want to buy banks’ toxic assets?

Prospective buyers hunt for the good stuff amid all the bad debt, anticipating a supersale.

ByRon Scherer, Staff writerMay 6, 2009

Michael Sloan

New York — Buying loans from banks – the types of loans that need to be handled with latex gloves and hazmat suits – is becoming a new growth industry.

Former mortgage bankers and Wall Street wheeler-dealers even now are leafing through confidential bank documents detailing tens of billions of dollars of bad mortgages and other loans known as “toxic assets.” Their goal: to find undervalued assets they can buy cheaply and make money on.

It may be chutzpah. It may be opportunism. Or it may be the solution to cleaning up the banks’ balance sheets. Whatever the case, many prospective buyers are mining for data that will help them in June, when a new government plan to deal with banks’ problems starts up.

The decisions made by loan sleuths on how much to pay for the banks’ bad holdings will determine the success of the government’s plan to try to move those holdings off the banks’ books. If the banks agree to the prices offered for their loans, the shifts in ownership of those loans could ultimately free up capital for the economy’s recovery. But if the banks balk because they believe the assets are more valuable, think about the economy in terms of molasses.

“It will be interesting to see who does participate,” says Paul Koches, executive vice president and general counsel at Ocwen Financial Corp., a mortgage servicing company. “We need to get this part of the economy unstuck from the mud.”

No doubt, there’s lots of opportunity. The combination of smelly loans and battered securities (pools of loans) on banks’ books may total as much as $2 trillion, say industry insiders. Less than $50 billion has been raised so far from private investors and institutions such as pension funds and endowments to buy some of these troubled assets.

A big part of the money that needs to be raised will go toward the federal government’s latest effort to take bad loans off the banks’ balance sheets: the Public-Private Investment Program (PPIP). This complex program will try to get the banks to sell bad loans (termed “legacy loans”) and legacy securities (containing lots of loans).

The buyers eyeing these loans have different histories and take different approaches.

“If anything, we are the good guys,” says David Spector, the company’s chief investment officer. “Homeowners actually like us.”

The reason home­owners may smile on PennyMac: After it buys loans from banks at a discount, it tries to work on loan modifications to prevent foreclosures.

But first, PennyMac does a lot of homework, analyzing every loan it is considering buying. The firm looks at payment histories and calculates the probability of default. It adds in regional factors pertaining to how much housing values have changed: A loan in Florida may be worth less than a loan in Wyoming, for example. And, of course, it factors in a 20 percent return on its investment.

Unlike the days of instant approvals for mortgages, the review process for each package of loans takes at least two weeks, usually longer.

PennyMac says it has looked at $60 billion worth of loans but purchased only $800 million. “It’s not a great hit rate because we are cautious,” Mr. Spector says.

Other prospective buyers of legacy loans are popping up on Wall Street, where the scent of money is particularly strong. For instance, at the end of 2007, Goldman Sachs purchased Litton Loan Servicing, which is responsible for a large portfolio of subprime mortgages.

“Firms like Goldman Sachs have been buying distressed mortgage-backed securities and individual loan portfolios since the meltdown occurred [last fall], buying them at a deep discount,” says Kenneth Alverson, a managing director at Novantas, a financial-services consulting firm based in New York.

Some buyers of distressed debt, Mr. Alverson notes, use sophisticated computer models that look at underlying default rates, the influence of the economy on homeowners, the direction of interest rates, and factors related to local metropolitan statistical areas (MSAs).

Other analysts on Wall Street have another approach: focusing on the few trades that do take place for a distressed security. One company taking this approach is Pluris Valuation Advisors, based in lower Manhattan. It has a licensing agreement to get data from SecondMarket, a Wall Street firm that does trading in illiquid, or distressed, securities.

“We believe as long as there is some kind of market, it gives us some kind of guidance of what the market is or what the value may be,” says president Espen Robak. “And that is a lot better than using a theoretical model with assumptions that who knows where they came from.”

For example, one “toxic asset” Mr. Robak has tracked is a $600 million Lehman Brothers deal that securitized some of the assets backing up a complex insurance product. “There is almost no market, but when the securities do trade, it’s for 10 to 20 cents on the dollar,” he says.

Why would people buy such securities? “Some people are speculating that these things will have a greater recovery [of investment] than what is expected today,” he says. But these securities sold by Wall Street “are real long shots, and they have serious losses.”

Of course, banks, too, are scrutinizing their portfolios to assess the value of mortgage-related debt. But future buyers “are looking for something the bank can’t find,” says Michael Burns, a lawyer who used to work at the Federal Deposit Insurance Corp. and is now at Anderson, Burns & Vela in Dallas. “The buyers’ strategy is to make money or turn a profit on a portion, such as 10 percent, of the loans in a pool that they purchase. They realize that the majority of the loans in a pool will not be profitable.”